Obiter Dicta: CAPE Ratio

Having recently written a bit on the Sharpe Ratio reminded me that I hadn't actually covered the CAPE ratio on my blog. This was particularly surprising as it was one of the first things that ボーイフレンド taught me, even before I had started my own portfolio.

Invented by the Nobel Prize winner Robert Shiller, it stands for Cyclically Adjusted Price to Earnings Ratio, also known as the P/E 10 Ratio. Starting again on fundamentals, PE ratio is one of the first tools that you learn in finance. It is simply calculated as follows:

It is a very blunt instrument that provides rough guidance on whether or not a share is overpriced. The higher the PE ratio, the more likely it is that a share is overvalued or a high growth is expected, vice versa, the lower it is the more likely it is undervalued or slow growth is expected. In comparing PE ratios, it is best to compare with competitors in the same industry or with the company's previous years' performance to ensure consistency of benchmark. Being a very simplistic indicator, it doesn't take into account projected earnings, especially for startups which may yet have started turning over a profit. It is also often limited by fluctuations experienced annually throughout the course of a business cycle.

This is essentially what lead to the creation of the CAPE ratio, to smooth out fluctuations in corporate profit over a decade. The formula for CAPE ratio is:

The use of the CAPE ratio for individual companies is largely to assess the long term financial performance to determine whether or not a share is over or undervalued. Limitations of the ratio include the fact that it is always only backward looking rather than forward looking and it doesn't take into account changes in accounting standards which may also affect the figures used in the calculations.

Other than for individual companies, I find that a far more useful application of the CAPE is in considering the historic CAPE ratio for an individual country. The CAPE Ratio by country is calculated by averaging a country's average equity price by their ten year average inflation adjusted earnings weighted by market capitalization. The resulting figure provides an indicator on whether or not the country's stocks are considered over or undervalued.

When considering a country's current CAPE ratio to it's historical average, we can determine the propensity for a substantial corrections in it's equity prices. From the chart below, it is clearly apparent that the crashes in US and Australian stocks corresponded to a much higher than average CAPE ratio, notably the dot com crash and the GFC. Therefore in the short to medium term, investing in a country with considerably above average CAPE ratio is likely to result in lower than expected returns in the foreseeable future.

It is also of interest to note that different countries' CAPE ratio cannot be compared against each other because different countries specialize in different industries with different average PE ratios, so a country's CAPE ratio ought only to be compared with it's own historical average.

Given the above, there is little doubt as to why CAPE ratio poses such a useful tool in measuring not only a company's stock but for a whole country's projected future performance. Definitely a worthwhile indicator to consider when assessing future investments.

by 小福